The Exponential Growth of Private Credit: Risky and Nearly Invisible

By Andrew Park, senior policy analyst

Since the Great Financial Crisis of 2008, one of the murkiest corners of the financial market – private credit – has exploded in size as investors chase higher returns. Private credit, also referred to as non-bank direct lending, has become the fastest area of growth in corporate lending. And unlike the corporate lending traditionally done by large banks like JP Morgan, Goldman Sachs and more, which are subject to oversight from the federal prudential regulators (the Federal Reserve, OCC and FDIC), this lending is done predominantly by private equity firms, and is mostly invisible to regulators. 

Opacity is the enemy of effective risk management, and this now $1.5 trillion dollar market represents a significant danger. Even the $1.5 trillion figure is only an estimate from data providers, with split of that $1.5 trillion between money that has already been invested versus yet to be spent not readily available to regulators and the public. There is no one entity that definitively knows even something as basic as the true size and composition of this market It is past time for regulators to work to establish some visibility into this market and to put guardrails in place so that any future disruptions to the market do not have significant knock-on effects throughout the financial system. 

Much of the non-bank direct lending flowed on the presumption that interest rates would stay unusually low, as they did for about 14 years following 2008. But now they are higher. Borrowing costs are linked to short – term interest rates which the Federal Reserve has been raising since 2022, so interest payments have been rising rapidly across the private credit market. 

Private credit funds, flush with money raised from a wide range of investors chasing higher returns, have taken advantage of the lack of regulatory scrutiny to capture a significant portion of the corporate lending market from the banks. In its most recent Financial Stability Report the Fed admitted: “the sector remains opaque, and it is difficult to assess the default risk in private credit portfolios.” the Fed report none the less said it was not particularly worried because leverage levels in the market were not excessive. We think they are underestimating the potential dangers.

This market’s exponential growth and lack of investor protection has led to aggressive competition among private credit funds to extend new loans using all the capital they have on hand raised from pension funds, insurance companies, university endowments, and wealthy individuals. With all this new money looking to be put to work, private credit lenders have increasingly been relying on very generous terms such as allowing borrowers to pay interest using additional debt rather than cash to make new loans. The asset management arm of Goldman Sachs (which is separate from the bank and operates more like a private equity firm) for example in mid-2022 made a $800 million loan to support Singapore’s sovereign wealth fund’s acquisition of Element Materials, allowing for “payment-in-kind” where interest is paid with additional debt rather than cash. 

There are also increasing concerns that some of the largest transactions in the private credit markets are not being used to support business growth, but rather to provide financing to companies who face dwindling options on their prior debts coming due. A prime example of that is a $6 billion private credit loan, which would be the largest on record, that is being considered by Oak Hill Advisors, Sixth Street Partners, and Ares Management to financial software company Finastra. The loan is not being made for new investments but rather to refinance $4 billion in debt that is coming due in 2024 that the company is struggling to repay. Rating agency Moody’s has already cut Finastra’s debt deeper into junk. 

It’s no wonder that Katie Koch, president and CEO of asset manager TCW Group commented that investors should prepare for “major accidents” in the private credit market over the next 12 to 18 months. “It is going to be pretty painful as defaults and downgrades increase,” according to Anne Walsh, chief investment officer at Guggenheim Partners. Blackstone, a major private credit provider, seems undeterred. Its COO, Jonathan Gray, calls the present period “a golden moment” for private credit.

Even if we don’t see a systemic crisis owing to private credit bubbles, we know the system has fragilities that policymakers have ignored for too long. The impact on the real economy could be great indeed. Since much of private credit is floating rate, businesses, struggling with repaying their debt as interest rates rise further, could see pressure to lay off employees and reduce investing in their business, leading to additional negative effects. But without better surveillance of this market, it will be hard to even see trouble coming.

The Treasury’s Office of Financial Research (OFR) was created by the Dodd-Frank law with a mandate to collect critical financial and economic data, research, and develop tools to identify and monitor risks within the financial system. Given the exponential growth in private credit and the risks a number of market participants are warning about, it is imperative for the OFR to conduct a study on the $1.5 trillion private credit market and recommend policy solutions to better monitor and supervise it. It grows larger and more intertwined with the real economy and the rest of the financial system with every passing day. Treasury and the OFR must not wait for a major accident to to focus on it and take action.